Managing Unfunded Partner Retirement Plans: Now's The Time To Consider Alternatives

Partnerships often provide supplemental retirement benefits to their partners. These plans were established many years ago, and in many cases, do not achieve many of the business objectives for the modern law firm.

Financially, firms do not typically set aside dedicated assets to meet these obligations. Thus, the obligations are actually passed from one generation of partners to the next, akin to the Social Security financing system, whereby active partners' earnings are diminished each year to fund the supplemental pension payments to already retired members. The dramatically increasing ratio of retired to active partners ' exacerbated by baby boomer demographics and the longer life spans of retirees ' has created enormous financial liabilities and sparked real questions of intergenerational equity within firm ranks.

This article will cover the origins and objectives of these programs and assess their modern day relevance. The article will discuss prominent current objectives a firm might have with respect to retiring partners, identify HR solutions to meet them, and suggest change management strategies to manage their unfunded retirement plans to satisfy both younger and older members of the firm.

Introduction

Today's law firm has to be smarter than ever about pursuing revenue growth and managing firm expenses. Since sustainable growth is dependent on having a stable lineup of the right people focused on the right things, compensation programs must support the creation of value for the firm. On the other hand, while expense reduction efforts may boost partner distributable income (PDI) temporarily, they are usually ineffective in driving the revenue growth that is the lifeblood of every law firm.

This article discusses the role supplemental, nonqualified partner retirement plans play in achieving these goals and why, for many firms, the underlying goals and objectives are outdated, resulting in a less effective linkage to value creation. We will describe how the “tails” of these obligations can span generations and may create significant headwind on delivering PDI to current partners. We will also offer alternative strategies and tactics that firms can use to limit the financial issues associated with these plans, and suggest how to re-deploy those dollars for higher return.

Types Of Plans And Why They Were Created

Supplemental, nonqualified retirement plans include a wide variety of arrangements that have the same basic premise ' to provide income to a partner after retirement, over and above any amounts that may be provided via firm-sponsored tax-qualified plans. These payments are far more often than not funded through current income as a claim on that year's PDI.

The two basic types of these plans are share-based (the retiring partner retains a profit interest) and compensation-based (the retiring partner is essentially a debtor). Each plan (regardless of basic type) has many additional provisions including retirement age, rules for vesting, the basis for determining benefits, the period over which income is paid, caps and other overall limitations on aggregate payments, etc. A typical plan might provide for payments for 10 years after retirement, based on the average actual compensation of the partner in the years prior to retirement, provided the partner has at least 20 years of service at retirement.

For the most part, unfunded partner plans were designed to carry out an implicit quid pro quo between generations: an intergenerational transfer of money. In effect, current partners paid former partners for the value they created while they were with the firm. At the time most were created, this transfer was harmless ' demographics, and time, were on their side. To some extent, these arrangements were viewed as golden handcuffs, encouraging partners to create value throughout their careers based on the promise of post-retirement earnings.

Financial Issues

Most firms' inability to retain capital limits their ability to fund these plans in advance. Left unchecked, these plans can have a significant direct drain on PDI. At the same time, the need to pay more attention to capitalization and equity finance (vs. debt), coupled with the encumbrance of these payments, has made capital calls more common when external financing isn't available at the right terms, further squeezing PDI.

Under the wrong circumstances, this intergenerational funding arrangement can be viewed as a sort of legal pyramid scheme. Similar to their fraudulent cousins, a fundamental instability of unfunded partner pension plans can occur when the growth rate of the liabilities is faster than profit growth. This can happen for several reasons. The aging of the workforce and the fast-approaching bubble of retirements from the baby boom generation has been well documented. This is certainly felt within the law firm industry that experienced a rapid growth rate of partnerships during the booming 1980s, and this explains why many law firms will have (or already have) a higher ratio of retirees to actives than will be seen in the general U.S. population. A less discussed but equally important factor driving liability growth is that partners are retiring earlier, living longer, and living “better” in retirement than ever before ' thereby simultaneously decreasing the period of retirement funding while increasing the actual cost of the retirement. Note that these longer life expectancies spawn derivative issues, such as the adequacy of payouts over a fixed period of years (eg, 10 years) as opposed to lifetime payments.

In response, some firms have used cost caps to balance intergenerational equity by managing the overall diversion of current profits to former partners. A typical plan might include a provision to cap retiree payments at 5% of PDI. However, cost caps can negatively affect the lifestyles of current retirees who see their payments reduced unexpectedly and, depending on the policies associated with the cap, can leave firms with the choice of either alienating retirees or watching a near-term problem compound.

In contrast, perhaps in recognition of these factors, some firms have adopted a “cash and carry” approach, abandoning their supplemental payments and communicating a limited role for the firm in financing individual retirements. The underlying philosophy is that with average partner income approaching (or exceeding) $1,000,000 at many firms, the need for golden handcuffs may be greatly reduced.

Changing The Perspective

Instead of focusing on financial and demographic pressures, firms can often find great benefit in adjusting plans based on the objectives for the plans rather than on the firm's history, situation and demographics. Thus, from a return on investment point-of-view the question can be framed: If the pension promises are projected to cause financial baggage that is large enough to prompt a cap on the size of these payments, then shouldn't the firm expect better results than it is getting?

The broader and more philosophical partnership issues to address are:

• Who is creating value and fueling revenue growth? How should these individuals be compensated while they are working? When they are retired?
• What is the firm's retirement policy (age, years of service) for partners and how are their key client relationships transferred upon their retirement?
• If none is already in place, should the firm have a mandatory retirement age for partners?
• What is the firm's role in and responsibility for the fiscal health of each partner in retirement?
• Has this strategy changed in light of the firm's current and expected demographics and PDI levels?

Change Management Strategies

One critical measure of success for managing the phase-out of unfunded partner retirement plans is that such a phase out should reduce, not increase, tensions between younger and older partners. To do this, the change must be viewed as integral to common values and goals and must treat each party as equitably as possible.

Here are some issues firms must consider when seeking to reduce or eliminate their dependence on unfunded pension benefits:

How fast is the retiree population growing? The longer a firm waits to address the issue, the larger the group of retirees may become, exacerbating the problem.

Have we communicated the full extent of the existing obligations to all partners? In anticipation of a vote, and as part of the redesign process, it is critical to forecast firm revenue, partner counts, and pension plan payouts for at least 10 years, including a sensitivity analysis that measures both the expected levels as well as the volatility/variations, so that worst cases may be identified and analyzed. Because lawyers tend to be analytical, they may need to fully understand a problem before they will consider alternative solutions.

Have we avoided creating a “caste” system? It can appear expedient to change the benefits for future partners and leave the current partners alone, but beware, this approach simply defers the pain and is rarely viewed as equitable, since it divides the group into “have” and “have not” camps. Seek genuine solutions that address the root cause ' fair compensation, funded by sound financing with implied future revenue growth rates that are reasonable. To the extent that the current structure has already created multiple constituencies, any solution will need to define why each class of partner should cast an approving vote.

Can payments be structured like debt, not equity? Design post-retirement income formulas to resemble debt (fixed dollar payments) like traditional defined benefit pension plans, and move away from equity-type arrangements (eg, where retired partners retain units or shares). This breaks the link between partner contributions and new revenues enjoyed after those contributions were provided. If necessary, convert existing unit/share plans to an equivalent dollar-based formula, thus eliminating the revenue escalator from future pension payouts and locking in the unit/dollar relationship on the last day of employment, just like in traditional pensions plans. Conversion need not be uniform; it is sometimes helpful to provide somewhat more advantageous conversion terms for those closest to retirement, on the grounds that they are afforded the smallest amount of time to change their retirement planning and saving to adjust to the new reality.

Can we optimize tax-qualified arrangements? Although the dollar amounts available for tax sheltering under qualified plans are usually insufficient for adequate partner retirement income, these plans nonetheless present an opportunity to set aside funds and deliver a meaningful benefit level. They also create desired tax deductions for partners. Often, there is room within the required nondiscrimination tests to deliver significant partner benefits within tax qualified plans with only minimal additional benefits (and cost) to staff. If a firm is not maximizing the results of the nondiscrimination tests, an opportunity is being missed.

Conclusion

A combination of these strategies can usually alleviate the burden of a non-qualified retirement plan in a manner that is acceptable to all partners. The time to begin addressing the firm's issues is now. The way to begin is to review the history of the plan and the reasons for its implementation. Then, management can compare those reasons to today's priorities and assess the current relevance of the plan. Each firm is unique, and there is no single solution or combination of strategies that can apply to all firms, but if left unaddressed, the costs of unfunded plans can be a firm's undoing.

Partnerships often provide supplemental retirement benefits to their partners. These plans were established many years ago, and in many cases, do not achieve many of the business objectives for the modern law firm.

Financially, firms do not typically set aside dedicated assets to meet these obligations. Thus, the obligations are actually passed from one generation of partners to the next, akin to the Social Security financing system, whereby active partners' earnings are diminished each year to fund the supplemental pension payments to already retired members. The dramatically increasing ratio of retired to active partners ' exacerbated by baby boomer demographics and the longer life spans of retirees ' has created enormous financial liabilities and sparked real questions of intergenerational equity within firm ranks.

This article will cover the origins and objectives of these programs and assess their modern day relevance. The article will discuss prominent current objectives a firm might have with respect to retiring partners, identify HR solutions to meet them, and suggest change management strategies to manage their unfunded retirement plans to satisfy both younger and older members of the firm.

Introduction

Today's law firm has to be smarter than ever about pursuing revenue growth and managing firm expenses. Since sustainable growth is dependent on having a stable lineup of the right people focused on the right things, compensation programs must support the creation of value for the firm. On the other hand, while expense reduction efforts may boost partner distributable income (PDI) temporarily, they are usually ineffective in driving the revenue growth that is the lifeblood of every law firm.

This article discusses the role supplemental, nonqualified partner retirement plans play in achieving these goals and why, for many firms, the underlying goals and objectives are outdated, resulting in a less effective linkage to value creation. We will describe how the “tails” of these obligations can span generations and may create significant headwind on delivering PDI to current partners. We will also offer alternative strategies and tactics that firms can use to limit the financial issues associated with these plans, and suggest how to re-deploy those dollars for higher return.

Types Of Plans And Why They Were Created

Supplemental, nonqualified retirement plans include a wide variety of arrangements that have the same basic premise ' to provide income to a partner after retirement, over and above any amounts that may be provided via firm-sponsored tax-qualified plans. These payments are far more often than not funded through current income as a claim on that year's PDI.

The two basic types of these plans are share-based (the retiring partner retains a profit interest) and compensation-based (the retiring partner is essentially a debtor). Each plan (regardless of basic type) has many additional provisions including retirement age, rules for vesting, the basis for determining benefits, the period over which income is paid, caps and other overall limitations on aggregate payments, etc. A typical plan might provide for payments for 10 years after retirement, based on the average actual compensation of the partner in the years prior to retirement, provided the partner has at least 20 years of service at retirement.

For the most part, unfunded partner plans were designed to carry out an implicit quid pro quo between generations: an intergenerational transfer of money. In effect, current partners paid former partners for the value they created while they were with the firm. At the time most were created, this transfer was harmless ' demographics, and time, were on their side. To some extent, these arrangements were viewed as golden handcuffs, encouraging partners to create value throughout their careers based on the promise of post-retirement earnings.

Financial Issues

Most firms' inability to retain capital limits their ability to fund these plans in advance. Left unchecked, these plans can have a significant direct drain on PDI. At the same time, the need to pay more attention to capitalization and equity finance (vs. debt), coupled with the encumbrance of these payments, has made capital calls more common when external financing isn't available at the right terms, further squeezing PDI.

Under the wrong circumstances, this intergenerational funding arrangement can be viewed as a sort of legal pyramid scheme. Similar to their fraudulent cousins, a fundamental instability of unfunded partner pension plans can occur when the growth rate of the liabilities is faster than profit growth. This can happen for several reasons. The aging of the workforce and the fast-approaching bubble of retirements from the baby boom generation has been well documented. This is certainly felt within the law firm industry that experienced a rapid growth rate of partnerships during the booming 1980s, and this explains why many law firms will have (or already have) a higher ratio of retirees to actives than will be seen in the general U.S. population. A less discussed but equally important factor driving liability growth is that partners are retiring earlier, living longer, and living “better” in retirement than ever before ' thereby simultaneously decreasing the period of retirement funding while increasing the actual cost of the retirement. Note that these longer life expectancies spawn derivative issues, such as the adequacy of payouts over a fixed period of years (eg, 10 years) as opposed to lifetime payments.

In response, some firms have used cost caps to balance intergenerational equity by managing the overall diversion of current profits to former partners. A typical plan might include a provision to cap retiree payments at 5% of PDI. However, cost caps can negatively affect the lifestyles of current retirees who see their payments reduced unexpectedly and, depending on the policies associated with the cap, can leave firms with the choice of either alienating retirees or watching a near-term problem compound.

In contrast, perhaps in recognition of these factors, some firms have adopted a “cash and carry” approach, abandoning their supplemental payments and communicating a limited role for the firm in financing individual retirements. The underlying philosophy is that with average partner income approaching (or exceeding) $1,000,000 at many firms, the need for golden handcuffs may be greatly reduced.

Changing The Perspective

Instead of focusing on financial and demographic pressures, firms can often find great benefit in adjusting plans based on the objectives for the plans rather than on the firm's history, situation and demographics. Thus, from a return on investment point-of-view the question can be framed: If the pension promises are projected to cause financial baggage that is large enough to prompt a cap on the size of these payments, then shouldn't the firm expect better results than it is getting?

The broader and more philosophical partnership issues to address are:

• Who is creating value and fueling revenue growth? How should these individuals be compensated while they are working? When they are retired?
• What is the firm's retirement policy (age, years of service) for partners and how are their key client relationships transferred upon their retirement?
• If none is already in place, should the firm have a mandatory retirement age for partners?
• What is the firm's role in and responsibility for the fiscal health of each partner in retirement?
• Has this strategy changed in light of the firm's current and expected demographics and PDI levels?

Change Management Strategies

One critical measure of success for managing the phase-out of unfunded partner retirement plans is that such a phase out should reduce, not increase, tensions between younger and older partners. To do this, the change must be viewed as integral to common values and goals and must treat each party as equitably as possible.

Here are some issues firms must consider when seeking to reduce or eliminate their dependence on unfunded pension benefits:

How fast is the retiree population growing? The longer a firm waits to address the issue, the larger the group of retirees may become, exacerbating the problem.

Have we communicated the full extent of the existing obligations to all partners? In anticipation of a vote, and as part of the redesign process, it is critical to forecast firm revenue, partner counts, and pension plan payouts for at least 10 years, including a sensitivity analysis that measures both the expected levels as well as the volatility/variations, so that worst cases may be identified and analyzed. Because lawyers tend to be analytical, they may need to fully understand a problem before they will consider alternative solutions.

Have we avoided creating a “caste” system? It can appear expedient to change the benefits for future partners and leave the current partners alone, but beware, this approach simply defers the pain and is rarely viewed as equitable, since it divides the group into “have” and “have not” camps. Seek genuine solutions that address the root cause ' fair compensation, funded by sound financing with implied future revenue growth rates that are reasonable. To the extent that the current structure has already created multiple constituencies, any solution will need to define why each class of partner should cast an approving vote.

Can payments be structured like debt, not equity? Design post-retirement income formulas to resemble debt (fixed dollar payments) like traditional defined benefit pension plans, and move away from equity-type arrangements (eg, where retired partners retain units or shares). This breaks the link between partner contributions and new revenues enjoyed after those contributions were provided. If necessary, convert existing unit/share plans to an equivalent dollar-based formula, thus eliminating the revenue escalator from future pension payouts and locking in the unit/dollar relationship on the last day of employment, just like in traditional pensions plans. Conversion need not be uniform; it is sometimes helpful to provide somewhat more advantageous conversion terms for those closest to retirement, on the grounds that they are afforded the smallest amount of time to change their retirement planning and saving to adjust to the new reality.

Can we optimize tax-qualified arrangements? Although the dollar amounts available for tax sheltering under qualified plans are usually insufficient for adequate partner retirement income, these plans nonetheless present an opportunity to set aside funds and deliver a meaningful benefit level. They also create desired tax deductions for partners. Often, there is room within the required nondiscrimination tests to deliver significant partner benefits within tax qualified plans with only minimal additional benefits (and cost) to staff. If a firm is not maximizing the results of the nondiscrimination tests, an opportunity is being missed.

Conclusion

A combination of these strategies can usually alleviate the burden of a non-qualified retirement plan in a manner that is acceptable to all partners. The time to begin addressing the firm's issues is now. The way to begin is to review the history of the plan and the reasons for its implementation. Then, management can compare those reasons to today's priorities and assess the current relevance of the plan. Each firm is unique, and there is no single solution or combination of strategies that can apply to all firms, but if left unaddressed, the costs of unfunded plans can be a firm's undoing.